THE EFFECT OF TRADE ON INCOME AND INEQUALITY: A

March 2017 CROSS-SECTIONAL APPROACH

Approved By Prepared By Diego Cerdeiro and Andras Komaromi

Valerie Cerra

CONTENTS

THE EFFECT OF TRADE ON INCOME AND INEQUALITY: A CROSS-SECTIONAL

APPROACH ....................................................................................................................... 2 
A. Motivation and Methodology ............................................................................................................ 2 
B. Results .......................................................................................................................................................... 3 
C. Conclusion.................................................................................................................................................. 6 

References ........................................................................................................................ 7 

FIGURES
1. Income and Inequality by Level of Openness ............................................................................... 2 
2. First Stage Regression: Estimated Coefficient and T-Statistic of
Constructed Trade Openness .......................................................................................................... 3 
3. Effect of Trade Openness on Real Income and Inequality ....................................................... 4 
BACKGROUND PAPERS

THE EFFECT OF TRADE ON INCOME AND INEQUALITY:

A CROSS-SECTIONAL APPROACH1
This background note is a short summary of the main results in a forthcoming working paper. We use countries’
exogenous geographic characteristics to construct an instrument for trade openness, and examine the cross-
country relationship between trade, income and inequality.

A. Motivation and Methodology

1. There is a strong correlation between trade and income, and trade and inequality in
the cross section of countries, but inferring causality is complicated due to endogeneity
problems. Countries with higher trade openness (exports plus imports as a share of GDP) tend to
have higher living standards and lower income
inequality. The gap between more open and less Figure 1: Income and inequality by level of openness
(average of countries in bottom and top tertile)
open economies in terms of their GDP per capita 12

and income Gini coefficient is persistent, and if 40

11
anything it has widened in the last two decades
(Figure 1). However, trade openness is arguably 10
36

endogenous in these simple bivariate

relationships as many variables that affect income 9 32

and inequality directly may also be correlated

8 28
with trade itself. For example, countries that
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adopt open trade policies may also pursue other
GDP per capita - Bottom tertile GDP per capita - Top tertile
market-friendly domestic policies and conduct Gini coef. - Bottom tertile Gini coef. - Top tertile
stable fiscal and monetary policies. Since these
policies are likely to affect income and inequality, trade openness is likely to be correlated with
important factors that are omitted from the naïve approach.

2. Countries’ exogenous geographic characteristics can be exploited to achieve causal

identification. As the literature on the gravity model of trade demonstrates, geography is a
powerful determinant of bilateral trade (e.g. Head and Mayer, 2014). A seminal paper by Frankel and
Romer (1999, henceforth FR) showed that one can use this insight to construct a valid instrument for
countries’ overall trade openness. In particular, they estimate a gravity equation that includes only
geographical variables such as bilateral distance, area, and whether the countries are landlocked,
and they aggregate the fitted values to obtain the predicted trade openness of each country. The
included geographic characteristics are unlikely to have important effects on countries’ income
except through their impact on trade. Thus, the constructed trade openness can be used to obtain

1
Prepared by Diego Cerdeiro and Andras Komaromi. This paper was prepared as a background study for the
Western Hemisphere Department’s Cluster Report on Trade Integration in Latin America and the Caribbean. This
paper describes research in progress by the authors and is published to elicit comments and to encourage debate.
The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its
Executive Board, or IMF management.

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 BACKGROUND PAPERS

instrumental variables estimates for trade’s impact on income. The authors use data from 1985, and
find that a one percentage point increase in trade openness raises GDP per capita by between 2 and
3 percent.

3. Adopting the FR identification strategy, we analyze the effect of trade on income and
inequality, and investigate the robustness of the results over time. We extend the work of FR in
three directions: First, in addition to real income per capita, we also estimate the impact of trade
openness on various measures of within country inequality. Second, instead of focusing on one
cross-section of countries at a given point in time, we utilize annual data from 1990 to 2015, and
check whether the estimated effects are stable qualitatively and quantitatively over time. Third, as an
improvement in the econometric methodology, we employ the Poisson pseudo–maximum
likelihood estimator to fit our gravity model of bilateral trade, which has a number advantages over
simple OLS.2 We also consider new robustness checks not present in the original work.

B. Results

4. Countries’ geographic
Figure 2. First Stage Regression: Estimated
characteristics consistently predict actual
Coefficient and t-statistic of Constructed Trade
trade openness, rendering our
Openness
instrument highly relevant. In line with
the literature, the coefficients in our gravity
models are strongly significant and
geographic variables account for a major
part of the variation in bilateral trade. As a
result, the constructed country-level
openness measure is also highly correlated
with actual trade openness even after
controlling for country size.3 Figure 2 shows
the point estimate and t-statistic of the
first-stage regression of the IV procedure
for each annual cross-section. Given that
openness also has non-geographical determinants, the point estimate is less than 1 – it ranges

2
The Poisson pseudo-maximum likelihood (PPML) estimator was popularized by Silva and Tenreyo (2006) in the
estimation of gravity models. PPML has several desirable properties for our application: (i) it admits zero bilateral
trade flows which need to be dropped for OLS due to the necessary logarithmic transformation; (ii) it remains
consistent even if the error term in the original gravity relationship is heteroskedastic; and (iii) the fitted values
directly yield an estimate of the level of bilateral trade, whereas OLS requires further to move from the estimated log-
linear relationship to the predicted trade levels.
3
Following FR, we control for country size when estimating the causal impact of international trade on income and
inequality. Larger countries tend to engage in less international trade but in more within-country trade as a share of
their GDP. Hence, the component of the constructed trade openness that is correlated with country size cannot be
used to estimate the effect of trade. For details, see the working paper version (Cerdeiro and Komaromi,
forthcoming).

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BACKGROUND PAPERS

between 0.5 and 0.9. Most importantly, the t-statistic shows that geography-induced openness is a
sufficiently strong predictor of actual openness to serve as a reliable instrument. In particular, the
usual rule of thumb that the first stage F-statistic should be greater than 10 is satisfied for every
cross section.4

5. Our cross-country estimates for trade’s impact on real income are consistently positive
and significant over time. Figure 3 shows our baseline results for the effect of trade on income and
inequality. According to the point estimates, a one percentage point increase in trade openness
raises real income per capita by between 2 and 5 percent (Figure 3a). These estimates are
overwhelmingly significant for all time periods. However, there is some time variation in the
estimated effect: after hovering between 3-5 percent since the early 1990s, the coefficients fell to
about 2 percent after the global financial crisis. The reasons for this decline are hard to pin down.5

Figure 3. Effect of Trade Openness on Real Income and Inequality

(a) Real GDP per capita (b) Income ratio (top/bottom decile)

4
The F-statistic can be readily obtained as the square of the t-statistic presented in Figure 2.
5
One should be cautious in interpreting changes in the estimated coefficients for two reasons. First, most of the
confidence bands include most of the other point estimates, so generally the differences are not statistically
significant. Second, the figures also show that the sample of countries changes over time because of data availability
constraints. The working paper version discusses possible explanations for the change in the estimated coefficients in
both the income and inequality regressions, including changes in the country sample.

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Figure 3. Effect of Trade Openness on Real Income and Inequality (Concluded)

(c) Market Gini coefficient (d) Net Gini coefficient

Notes: Results from IV estimation of the regression: ln ln , where is trade openness, and and
are population and area. The figures show the estimated coefficient on trade openness (dots) and the 95 percent confidence
intervals (spikes). The number of countries in the sample is shown on the right axis (squares). Trade openness enters the
regressions in decimal form. The dependent variables ( ) in the four panels, respectively: log real GDP per capita (PPP-adjusted),
log ratio of the average income of the top and bottom deciles in the population, and the market and net Gini coefficients on a 0-
100 scale. The real incomes by decile are from the World Panel Income Distribution database (Lakner and Milanovic, 2016) and
the Gini coefficients come from the Standardized World Income Inequality database (Solt, 2016).

6. The evidence suggests that, if anything, trade tends to reduce overall income
inequality. Panel (b) shows trade’s impact on the top-to-bottom income ratio for the available
vintages of data. Point estimates suggest that one-percentage-point higher openness causes the
income of the top decile to decrease by about 4 percent relative to the income of the bottom decile
of the income distribution. This estimated effect is significant across all vintages. Panels (c) and (d)
show the estimated effect of trade openness on the market and net Gini coefficients, respectively.
Again, almost all of the point estimates suggest an inequality-reducing effect of trade. Moreover, for
a number of years the estimates are significant, especially for the net Gini coefficient. The
insignificant results and the few positive estimates all emerge for the more recent time period
simultaneously with a dramatic drop in the number of countries in the sample. Overall, the
estimated impact of trade on the Gini coefficient is fairly large, considering that these inequality
indicators tend to move quite slowly over time.

7. Our results are qualitatively unaffected under various robustness checks. The
methodology requires bilateral trade data for a large number of countries to construct the
instrument. Since this is only available for goods, in our baseline regressions we calculate openness
using only merchandise trade. However, we confirmed that the instrument is also relevant for trade
openness including services, and that our results remain broadly unchanged both qualitatively and
quantitatively. Another concern about our geography-based identification strategy is that systematic
differences among parts of the world may drive the results. To address this issue, we follow Hall and
Jones (1999) and include countries’ distance from the equator as a control variable. This variable
may reflect the impact of climate, or it may be a proxy for omitted country characteristics that are
correlated with latitude. With this approach, the estimated effects are smaller, but the qualitative
message is the same: trade improves living standards and there is no statistical evidence for any

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negative effect on aggregate income inequality. Finally, we demonstrate that our results are mostly
driven by non-European, and hence less developed countries.

C. Conclusion

8. Despite aggregate benefits, policies need to address the short and medium term
adjustment. Given that the results are based on cross-country data, they should be interpreted as
the long-run estimated effect of trade on real income and overall inequality. Thus, the estimates do
not shed light on possible temporary adjustment costs from greater integration. Moreover, it is
worth noting that although the estimates indicate that over time there are substantial benefits from
trade, they are silent about the channels through which this effect operates. In this regard, more
disaggregated studies are essential to help design policies that tap trade integration to spur growth.

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References
Cerdeiro, Diego, and Andras Komaromi, forthcoming, “Trade, Income, and Inequality in the Long
Run,” IMF Working Paper (Washington: International Monetary Fund).

Frankel, Jeffrey A., and David H. Romer, 1999, “Does Trade Cause Growth?,” American Economic
Review, June, Vol. 89, No. 3.

Hall, Robert E., and Charles I. Jones, 1999, “Why do Some Countries Produce So Much More Output
Per Worker than Others?,” The Quarterly Journal of Economics, 114 (1): 83-116.

Head, Keith, and Thierry Mayer, 2014, "Gravity Equations: Workhorse, Toolkit, and Cookbook," chapter
3 in Gopinath, Gita, Elhanan Helpman, and Kenneth Rogoff (eds), vol. 4 of the Handbook of
International Economics, Elsevier: 131–195.

Head, K., and T. Mayer, 2014, "Gravity Equations: Workhorse,Toolkit, and Cookbook," chapter 3 in
Gopinath, G, E. Helpman and K. Rogoff (eds), vol. 4 of the Handbook of International Economics,
Elsevier: 131–-195.

Lakner, Christoph, and Branko Milanovic, 2016, "Global Income Distribution: From the Fall of the Berlin
Wall to the Great Recession," World Bank Economic Review, World Bank Group, vol. 30(2), pages
203-232.

Santos Silva, J.M.C., and Silvana Tenreyro, 2006, “The Log of Gravity,” The Review of Economics and
Statistics, 88(4), pp. 641-658.

Solt, Frederick, 2016, “The Standardized World Income Inequality Database,” Social Science Quarterly
97(5):1267-1281.

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